The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Wednesday, March 20, 2013

A zillion banks, the futile search for one set of rules

In a column by the Bloomberg editors, they discussed how in the aftermath of the financial crisis the global financial regulators agreed there should be one rulebook for all financial institutions.

As predicted by your humble blogger, this search for one rulebook with complex rules like the Basel III capital regulation has proved futile. This was predictable because by definition the bank regulators could be easily played against each other by the banks.

The large, global banks understand that it is easy to trigger a race to the bottom in regulation by simply threatening to move their business and the taxes it pays to another country with less rigorous regulations.

There is only one regulation that can be applied globally. There is only one regulation that does not trigger a race to the bottom, but rather a race to the top.

That regulation would be to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

It triggers a race to the top because any bank that says it is unwilling to comply with this regulation is waving a large red flag saying it has something to hide.

What investor wants an exposure to a bank that is saying it has something to hide? What country would let a bank in that says it has something to hide?

It is only transparency that is a regulation that can be applied globally.

Shortly after the financial crisis spread around the globe like a plague, the world’s leaders developed what they thought would be an antidote.

Working through the Group of 20, they agreed to adopt common rules for all financial companies, no matter where they operated.

The global system would be less risky, the thinking went, if derivatives dealing, an opaque $639 trillion market, worked more like stock trading on exchanges. If large banks had more capital, they would be able to absorb losses so taxpayers wouldn’t have to. And if money-market funds and other parts of the shadow banking system were more tightly regulated, there would be fewer hidden risks....

Do you notice that transparency into all the opaque corners of the financial system was not on the list and therefore the hidden risks that precipitated the financial crisis are not addressed?

Sure the regulators focused on "price" transparency, but price transparency is not crucial to the functioning of the global financial system. What is crucial to the stability and functioning of the global financial system is "valuation" transparency.

Regular readers will recall that the investment process has 3 steps:

First, buyer and seller independently assess the risk of and value a security. This is where valuation transparency comes in. What is needed for valuation transparency is all the useful, relevant information in an appropriate, timely manner.

Second, buyer and seller obtain a price from Wall Street for the security. This is where the price transparency that the regulators are fixated on comes in.

Third, buyer and seller compare the price from Wall Street with their valuation of the security. They engage in a transaction based on this comparison.

Without valuation transparency, step one of the investment process cannot be completed.

If step one cannot be completed, any purchases or sales of securities without valuation transparency are simply blindly gambling on the contents of a black box.

But the dream of convergence remains, well, a dream. Conflicting national and regional laws, regulations and accounting standards have blocked the world from getting on the same page on financial reform. This, in turn, has jeopardized the ability of regulators to work across borders to address the next crisis.

Shutting down a large failing bank that, say, loses all its capital because of a trading strategy gone haywire isn’t possible without universal rules for resolving sick banks. Moreover, financial companies will be able to take advantage of regulatory arbitrage -- shifting operations to countries with the loosest rules.

Another rift is between Europe and the U.S. -- this one over capital requirements. New rules being written in Basel, Switzerland, have been watered down after much bickering. The level is now set at 7 percent of risk-weighted assets, up from 2 percent. Still, it falls short of the 10 percent initially sought by the U.S., and way short of the 20 percent of total assets that some economists and academics recommend. France and Germany led the opposition, seeking to protect the interests of their biggest lenders, which would have needed to raise more capital than foreign competitors, Bloomberg News has reported.

Not only is the global financial system no safer now than it was in 2008, it’s also clear that the project of convergence is badly stalled.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.